systemic risk

September 17, 2013

The dominant narratives now circulating five years after the height of the financial crisis typically conclude that the financial system is still very risky, or even riskier, since the September 2008 fall of Lehman Brothers.

While it is true that banks are still too big, too leveraged, and too short-term-funded, it is important to emphasize that the financial system is much safer because its most dangerous aspects is now a relic.

Specifically, mortgage-backed shadow banks no longer exist. The run up to the financial crisis saw the explosion of various types of securitization vehicles that were collateralized by private-label residential mortgage-related securities. These vehicles took the form of second-level securtizations financed by long- and medium-term liabilities (cash and synthetic collateralized debt obligations) and vehicles that largely issued commercial paper (asset-backed commercial paper conduits and structured investment vehicles).

As plenty of academic research has documented, bank-like "runs" on the short-term funding vehicles precipitated the financial crisis and made it especially severe in the fall of 2008. These runs caused banks to lose financing and suffer direct losses as the vehicles' losses became their own.

But mortgage-backed securitizations funded by short-term liabilities are a thing of the past. According to SIFMA statistics, outstanding U.S. asset-backed commercial paper plummeted from a peak of $1.1 trillion in 2006 to $262 billion by August 2013--and whatever remains is not collateralized by residential mortgage-related securities.

In addition, the amount of liabilities shadow banks issue are likely to continue to decrease. As noted in a June 2013 Standard and Poor's research report, the total liabilities of all shadow banks may even "fall below total deposits in the banking sector sometime in 2014," which would be a first since 1993. Lack of investor appetite and changes to capital regulation and off-balance-sheet accounting standards are the likely causes.

The following graph from the S&P report illustrates the trend:

Although new bank regulations are pushing credit activity into shadow banks, the fact that the most dangerous types of them are no longer financing the core of the financial system is--five years after the crisis--something worth celebrating.

November 09, 2012

"Highly interconnected" aptly describes the modern financial system and motivates widely shared concerns about it.

Former banker and fund manager Richard Bookstaber, for example, views the "tight coupling" of various aspects of the financial system as fraught with risk and prone to crashes. Lawmakers and regulators, for their part, do not want institutions to become too interconnected to fail.

But it seems that the evolution of financial markets and the effects of financial reform may result in markets becoming more interconnected than ever. Or least interconnected in new ways when it comes to the all important issue of collateral.

To help make the most out of scarce, high-quality collateral, banks and other financial firms have been increasingly focusing on collateral management. But regulatory reforms mandating the use of high-quality collateral for derivatives trades and other transactions has also spurred the activity known as collateral transformation, which involves trading lower quality collateral, such as risky corporate bonds, for higher quality collateral like government bonds or cash.

Estimates of how much collateral will ultimately be required to
comply with new regulations vary greatly and range from $500 million
to $2.6 trillion, as noted by Bloomberg. Proposed Basel III bank capital regulations, for example, would require bilateral over-the-counter derivatives trades to be collateralized with cash, high quality bonds and equities, or gold. Firms lacking the qualifying collateral could trade up to comply.

A potential source of high-quality collateral may come from outside the banking system--from corporations flush with cash. In summarizing the November 6th, 2012 remarks of Vanaja Indra, Risk.net reported that

Cash-rich corporates could ride to the rescue...Many of these have enjoyed high profitability over the past few years and have stockpiled cash to defend ratings or build takeover war-chests. Apple, Microsoft, Cisco Systems, Google and Pfizer had a combined cash balance of $276 billion at the end of 2011, according to one report from Moody's Investors Service.

By removing some of the funding risk outside of the banking system, corporate cash lending may reduce systemic risk. But if corporations begin seriously lending their cash in exchange for lower quality assets, the real economy will become interconnected with the financial system in an unprecedented way.

So who knows, maybe sometime soon your next iPhone purchase will help to fund a derivatives trade.

October 08, 2012

Republican Presidential candidate Mitt Romney stirred controversy after last week's presidential debate where he referred to the landmark Dodd-Frank Act of 2010 as "the biggest kiss given to New York banks I've ever seen" because it "designate[s] five banks as too big to fail and give[s] them a blank check."

Critics of Romney's position, such as Rep. Barney Frank (D-Mass.), responded by asserting that Dodd-Frank's new resolution authority for winding down failed banks actually prohibits bank bailouts and that any government funds used to assist banks must be repaid by an industry-wide assessment fee.

Dodd-Frank Allows the Government to Bail Out Banks

While it is certainly true that Romney greatly exaggerated his point in the debate, he did identify an important truth: Dodd-Frank still allows government bailouts of systemically important financial institutions.

Although Dodd-Frank fortunately makes it more difficult for failed or troubled financial institutions to receive government support, the Act does permit government bailouts or fails to prohibit them entirely:

Dodd-Frank permits the Federal Deposit Insurance Corporation (FDIC) to bail out short-term creditors of financial institutions, including their commercial paper and repo lenders. The
FDIC may obtain funds to lent to short-term creditors from the Treasury
Department, and in an amount that is largely determined by what the FDIC deems
as being the "fair value" of a failed institution's assets. And while it's true that the FDIC must repay the Treasury by charging
a fee to other financial institutions, the fee is assessed only after
a bailout takes place. This ex-post funding creates an implicit subsidy
on risk taking because it is unlikely that the assessment will be able
to be fully paid after a financial crisis, and certainly not by the firm
that failed.

Dodd-Frank does not prohibit the FDIC from borrowing up to $100 billion from the Treasury for "insurance purposes" to protect unsecured creditors. This regulatory power is given to the FDIC under 12 U.S.C. § 1824(a) and would require the FDIC's funding to take place outside Dodd-Frank's liquidation authority.

Dodd-Frank allows the FDIC to provide full protection to a financial institution that owns a failed bank under the systemic risk exception to the Federal Deposit Insurance Act. This type of bailout is limited to situations where overall financial stability is at stake and approval has been obtained from the Treasury Secretary and the Federal Reserve.

Dodd-Frank permits troubled financial institutions to borrow under the Federal Reserve's section 13(3) authority, so long as the Treasury Secretary approves and the funds are made available broadly and only to financial institutions deemed to be fundamentally solvent.

Dodd-Frank still permits troubled institutions to borrow on an individual basis from the Federal Reserve's discount window or the Federal Home Loan Bank.

Professor Arthur Wilmarth explains these Dodd-Frank loopholes in detail in an insightful March 2012 article arguing that bank activities should be highly circumscribed by law.

The Market Believes Future Bailouts Will Take Place

Would the foregoing potential sources of government funds for failed or troubled financial institutions be used? In the midst of another financial crisis, it is difficult to imagine that these sources would not be used, especially if beneficial politically.

Indeed, a 2012 study by International Monetary Fund researchers Kenichi Ueda and Beatrice Weder di Mauro estimated that the expectation that governments will provide assistance to large financial institution creditors decreases the institutions' borrowing costs by 0.8 percent. And as Bloomberg's Christine Harper and Hugh Son recently noted, federally insured funds in the form of deposits subsidize risk taking by banks and their affiliated financial institutions on an ongoing basis.

It's hard to characterize Dodd-Frank as a big kiss to banks since it imposes costly regulation on all of them, and most especially on the ones deemed too big to fail. But Dodd-Frank does leave the door open for the creditors of large banks and other financial institutions to receive government support. So while Dodd-Frank is not really the kiss that Romney described, it should at least be viewed as a governmental embrace of certain financial creditors.

June 06, 2012

JP Morgan's ongoing multibilion dollar loss from credit default swap (CDS) trades shares some disturbing similarities to the CDS trades that caused AIG to collapse in 2008. In both cases, the firms sold massive amounts of CDS protection. By 2007, AIG had sold in notional value $78 billion in ultimately ruinous CDSs. By some estimates, JP Morgan is currently long as much as $100 billion in losing CDS positions. In both cases, the regulators and executives that should have prevented or at least known more about the trades were caught blindsided. Reliance on flawed risk models also enabled both firms' losses.

Yet as Congress focuses on JP Morgan's CDS losses in its hearing today with bank regulators, and next week with JP Morgan CEO Jamie Dimon, it is worth noting that there are crucial differences between JP Morgan's and AIG's CDS losses. The differences are important because they indicate that the CDS market has become much safer than it was prior to the financial crisis, even if particular firms still misuse the instruments.

The first and most significant difference is that JP Morgan sold protection referencing a far more rationally priced and liquid market than did AIG.

JP Morgan's losing trades reference an index of North American investment grade bonds (the Markit CDX NA IG Series 9). Although bonds are not as liquid as stocks, the market for corporate bonds is robust and pricing is readily available. AIG, by contrast, sold CDSs referencing residential mortgage-related securities. When AIG was selling these CDSs, residential mortgage-related securities were mispriced, and the instruments were rarely traded and difficult to value.

Indeed, the efficiency of the corporate bond market underlying JP Morgan's trade explains why JP Morgan's massive CDS position distorted the CDS market in a way that became readily apparent to its counterparties. In the case of AIG, the market distortions caused by its mortgage-related CDS trades led it to become the "golden goose" underlying the mispriced synthetic securitization market of the better part of the last decade.

Importantly, the CDS market today poses much less of a risk to the financial system because CDSs are rarely written on illiquid mortgage-related securities any longer, in large part because of the shut down of private-label mortgage securitization since the financial crisis. This shut down is reflected in the following figure by Paul Rowady (page 68), which shows the collapse of special purpose shell entities selling mortgage-related CDSs:

Different Types of Risks: Market Value Versus Cash Crunch

The second major difference is the types of risks that arose from JP Morgan's and AIG's CDS trades. While JP Morgan's failed CDS trades are causing it unrealized paper losses, AIG's CDS trades caused it to practically run out of cash overnight and created risk for its counterparties and the economy.

AIG posted nearly $20 billion in collateral by August 2008 as the market value of the securities referenced by its CDSs plummeted. AIG was later bailed out by the government when it was unable to meet a second $20 billion collateral call from its mortgaged-related CDSs. AIG's collateral posting obligations were so large and sudden in part because it never posted collateral when the trades were first executed.

By contrast, the losses to JP Morgan from its CDS trades require the firm to reduce the balance sheet value of its CDS positions. JP Morgan was required to mark down the value of its CDS trade because the price of the reference index increased, thereby decreasing the value of the CDS protection it sold. Although JP Morgan's paper loss will reduce its profits, may require it to set aside or raise more capital, and lead to a realized loss once the trade comes to completion, it is unlikely that JP Morgan will actually have to make a cash pay out under its CDS trades. This is because the likelihood of default of any of the investment grade companies making up the referenced index is low.

Due to these differences, one should think twice before drawing conclusions about the CDS market based upon analogizing between JP Morgan and AIG.

May 15, 2012

Many details of the credit derivatives position that caused JP Morgan (JPM) to recently lose at least $2 billion are unknown. Yet based on the company's disclosures and media accounts of the trade, the Volcker Rule as proposed in October 2011 may end up encouraging the type of risk taking underlying JPM's losing position, if the Rule is implemented as proposed.

The Volcker Rule bans proprietary trading by banks and their holding companies, affiliates, and subsidiaries. As noted on page 67 of the proposal, the Rule's "hedging exemption" permits banks to engage in otherwise prohibited trading to hedge, but only if the hedging transaction does "not give rise, at the inception of the hedge, to significant exposures that are not themselves hedged in a [second] contemporaneous transaction."

The problem is that while entering into a secondary hedging transaction may initially reduce risk, it may also leave banks with even riskier positions that are difficult to manage in the long-run. Indeed, JPM's losing trade exemplifies just this sort of risky secondary hedging transaction.

To hedge its exposures from holding high-grade corporate bonds, JPM bought credit protection on a credit default swap (CDS) index referencing corporate bonds. However, this primary hedging transaction itself exposed JPM to at least two new risks. First, in accordance with accounting rules, JPM had to mark-to-market the value of its CDS index hedging transaction, which means that the primary hedge exposed JPM to market price risk. Second, the primary hedge also exposed JPM to the risk that the other side of the hedging transaction would be unable to pay, or counterparty risk.

To hedge these new risks, JPM also entered into another hedging transaction where it sold protection on a related CDS bond index. To borrow a metaphor from the New York Times, JPM put an umbrella on an umbrella. Importantly, not only was this sale of CDS protection the part of the transaction that ultimately led to JPM's $2 billion loss, but it was also the type of secondary hedging transaction that could be required by the Volcker Rule. When the secondary hedge was entered into 2011, it seems to have been an appropriate hedge for the primary hedging transaction.

None of the foregoing implies that JPM's loss was caused by anything other than its own mismanagement. However, given that secondary hedging transactions seem ripe for such mismanagement, the fact that the Volcker Rule seems to encourage them to qualify for one of its exemptions is troubling. It suggests attempts to micro-manage bank risk taking through regulation could seriously backfire, and that higher capital requirements or limiting the size of banks will be more effective in reducing systemic risk than the Volcker Rule.